The thoughts of Michael Cadwallader. Coffee loving, history book reading, Cheshire man.

Friday, May 12, 2006

Economic Warnings

The last few days have provided a plethora of stories on the state of UK plc. The most important of which, was B of E Governor Mervyn King's analysis of the state of our economy.

He tackles the current state of the housing market:

The level of house prices still seems remarkably high relative to those measures that put it into context

He then concludes that we are, as a country, addicted to debt. Perhaps we are just following the example of our Chancellor?

He then raises an issue that seems to be ignored by the media, Britain's massive trade deficit:

The country's current account deficit at around 4pc of GDP would need to be addressed, according to Mr King, but he was unsure over what time-frame this would need to be tackled.

He said: "We keep running current account deficits which means that we're spending as a country more than we're producing. And there is a limit in the long run to that."

What exactly - apart from Financial services - is it that we do produce in this country? We have been saved from economic reality too long thanks to North Sea oil. The impact of North Sea Oil cannot be underestimated, for in 1985 when it reached full capacity, the cumulative balance of payments saving totaled approx. 155bn or, more than 1/3 of that year's GDP. Despite that windfall, the reckless Lawson 'Barber Boom' still managed to run up large deficits. The North Sea Field peaked in 1999. However, we haven't really felt the pinch as the record oil prices have offset the losses, less oil goes further, so to speak. The reality is that despite King's pleas, our deficit is only going to get worse.

In its quarterly inflation report, the Bank said inflation would move above 2% in the short term as a result of higher gas and energy bills.

However, it is expected to be back on target within two years.

Despite the Bank's comments, analysts said a rise in rates before the end of the year appeared unlikely.

The latest report follows the Bank's recent vote to keep interest rates at 4.5%, for the ninth month in a row.

Speculation had been rising that the Bank may seek to raise rates in the summer to head off inflationary pressures.

This brings us back to the housing market. For the fact is that as we are a nation in debt, large rises in interest rates, to combat inflation are simply not an option. Thatcher's 'medicine' to tackle inflation, would be a disaster in the current economic climate. So, will tiny increases in the interest rates really bring down inflation? I have no doubt that Mervyn King is an economist of the very highest order, but he seems wildly optimistic:

"Clearly the rise in energy prices in the short term will add to the squeeze we've seen in the last year or so and is more likely to discourage consumer spending, but we've also seen a rise in asset prices and share prices," Mr King said."

My belief is that the rises in energy prices are permanent. So does Stephen Leeb. It's simple supply and demand, and thanks to our Chinese friends, there is not enough to go around. Perhaps Leeb exaggerates, when he talks of double digit inflation. But, we are using more oil than ever before, at a time when new discoveries are drying up. Leeb believes that the Fed and therefore, probably the BofE as well, would keep interest rates low to keep the economy going, and let the inflation level rocket up.

My advice is to invest in the ultimate inflation hedge, gold. And whatever you do as chancellor, don't sell off your gold bullion and invest it in Euro's. Umm....I forgot about that.